Nobel laureate predicts breakup of EU

A Nobel laureate in economics says there is a risk of another financial crisis because of the high debt levels of European banks. Professor Robert Engle of New York University says European policymakers are not doing enough to solve the continent's debt problems. He has also warned that the Japanese banking system could implode and the fallout could hit Australia.

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SALLY SARA: A Nobel laureate in economics says there's a risk the European Union could break up within a year because of the high debt levels of European banks.

Professor Robert Engle of New York University won the Nobel Prize in 2003 for developing a mathematical model which measures risks in financial markets. He says European policymakers are not doing enough to solve the continent's debt problems.

Professor Engle has also warned that the Japanese banking system could implode and the consequences could hit Australia.

Finance reporter Sue Lannin prepared this report.

SATIRICAL CLIP, FEMALE VOICE: If you're a Wall Street bank exposed to European banks who are exposed to infected nations who are exposed to Wall Street banks, ContagionX is for you. ContagionX, just because it's your fault doesn't mean others can't suffer for you.

(laughter)

SUE LANNIN: A satirical look at the bail-out of Wall Street giants at a conference in Sydney held by the University of New South Wales' Institute of Global Finance. The conference is looking at issues including systemic risk, which is what happened when US investment bank Lehman Brothers collapsed September 2008. The shockwaves triggered the global financial crisis.

Conference keynote speaker, Professor Robert Engle, is from New York University's Stern School of Business.

ROBERT ENGLE: Lehman Brothers is one of the big examples of this. The failure of Lehman Brothers precipitated the worst financial crisis we've had in 80 years, something like that.

SUE LANNIN: Professor Engle won the Nobel Prize in economics in 2003 for devising a mathematical model to calculate volatility in financial markets. He says there is a risk of another financial crisis because of the huge debts of European governments and banks.

ROBERT ENGLE: We had what I call the first financial crisis with the subprime mortgages in the US and we're now seeing what is likely to be the second one in the sovereign debt crisis in Europe.

SUE LANNIN: How much money is needed to recapitalise or inject more money into European banks?

ROBERT ENGLE: We have an estimate, so our number for the eurozone as a whole is about $1.5 trillion now.

SUE LANNIN: Do you think the governments, in particular the European Union, are they doing enough to try and solve the European debt crisis or is there more to be done?

ROBERT ENGLE: There is clearly more to be done. The problem with solving the European debt crisis I think is importantly political, in that there is a question of really who is going to pay and who is going to receive the money.

SUE LANNIN: Is there a real risk of another meltdown?

ROBERT ENGLE: I think so.

SUE LANNIN: How big would you rate the risk?

ROBERT ENGLE: I think there is a reasonable chance that the European Union will actually separate.

SUE LANNIN: So what - 25 per cent?

ROBERT ENGLE: I don't have a number for that, but your number is OK.

SUE LANNIN: And what timeframe?

ROBERT ENGLE: I think we're talking about a year or two.

SUE LANNIN: He is also worried about banks in Japan and China.

ROBERT ENGLE: The Japanese banks are taking on more and more leverage which means more and more risk. And consequently I think investors are reducing the amount they're willing to pay for the stocks in these banks, which makes it harder and harder for them to raise capital to keep their capital cushion.

SUE LANNIN: If there was a blow up in Japanese banks what impact would there be on Australia?

ROBERT ENGLE: I think it would probably be fairly substantial on Australia as well as well as actually on the rest of the world. Japan is the number three economy in the world.

SUE LANNIN: The Reserve Bank's Guy Debelle is more relaxed about the impact on Australia.

GUY DEBELLE: I looked at Robert's chart, it showed that, I don't know, it was about 10 per cent of GDP (Gross Domestic Product) that the Japanese banks needed in terms of extra capital, and the debt stock's 250 per cent of GDP, so another 10 per cent actually, if you look at it that way, isn't all that much.

SUE LANNIN: Guy Debelle says local banks are now in better shape than they were before the GFC because they have more reserves on their books.

GUY DEBELLE: If you think about the extreme stress that 2008 brought, which was basically a shutdown of all markets, well that's about as extreme as you get. If you look forward, I think the banks have got themselves in a much more stable funding position.

SUE LANNIN: But Jim Murphy, deputy head of the Treasury Department, says the GFC highlighted the dependence of Australia on the rest of the world.

JIM MURPHY: The soundness of Australia's regulatory and banking systems meant that we experienced less lasting impacts from the global financial crisis than other countries. Nevertheless the crisis showed our dependency on global financial markets, and how quickly poorly functioning markets can damage an economy.

SUE LANNIN: Credit ratings agency, Fitch Ratings, says Australian banks could face more challenges in 2013, including the slowing economy and a slowing China. Westpac's head of treasury, Curt Zuber, says the main issue facing Australian banks now is more complex regulation.

CURT ZUBER: I think some of the challenges going forward is not so much the really big rocks - the capital and the liquidity things - that we're transitioning to, it's the complexity that comes out of banks around the world and systems around the world right size their regulation and what impact that has.